Work smart and think creative!!: M&A: Restructuring and Leveraged Transactions

Definition:

"Restructuring is the corporate management term for the act of reorganizing the legal, ownership, operational, or other structures of a company for the purpose of making it more profitable, or better organised for its present needs. Other reasons for restructuring include a change of ownership or ownership structure, demerger, or a response to a crisis or major change in the business such as bankruptcy, repositioning, or buyout. Restructuring may also be described as corporate restructuring, debt restructuring and financial restructuring."

"A significant modification made to the debt, operations or structure of a company. This type of corporate action is usually made when there are significant problems in a company, which are causing some form of financial harm and putting the overall business in jeopardy. The hope is that through restructuring, a company can eliminate financial harm and improve the business."

Major restructuring transaction:

Asset restructuring --> asset sales, merging division, adding division
Ownership restructuring --> changing the ownership structure of either parent or division
Liabilities restructuring --> changing the debt/equity ratio
Rationale: to create value by reversing the negative consequences of:

conglomeration/corporate diversification.
value destroying M&A or over-investment --> hubris mgt, agency issues.
sub-optimal capital structure --> has not borrow enough or not capture optimal benefits of debt.
financial distress --> too much debt/equity ratio.

Benefits and costs of corporate diversification

More synergy by sharing a common headquarter.
Create internal capital markets (could trade each others and makes profit)
Tax advantages (tax-loss acquisitions, interest tax shield, basis step-up)
Avoid dependence on one product line and greater stability of profits since if one division experience losses, other may create profits.

Lack of diverse capabilities, lack of focus, duplication and wastes.
Cross-subsidisation and inter-division politics.
Symptomatic of over-investment or free cash flow problems.
Twin-agency problems: difficulties in monitoring divisional managers --> lack of information to capture division/individual performance.
Opportunity costs of potentially greater synergies if the assets are deployed elsewhere.

divestiture announcement usually increase shareholders wealth, greater than zero.
divestiture announcement have a negative effect on competitors share price.
larger divestment --> larger price increase
Divestment of unrelated non-core business --> larger price increase
asset sold --> larger price increase.

Ownership Restructuring:

a sale of a subsidiary, division or product line to a 3rd party, generally in a private transaction.
Raising cash to strengthen seller's financial conditions.
Assets are revalued to reflect expected CF under buyer mgt.
Subject to taxable capital gain/losses --> tax liability can be huge.
Control benefits: better use of assets --> assets are undervalued, target not efficiently using them or may be in financial distress situations.

initial public offering (IPO) of stock in a wholly owned subsidiary.
New public shareholders own control of subsidiary.
parent firm typically retains a controlling interest in the carved out subsidiary (median 80%).
means of raising funds (cash) in the capital market
after carve-out, subsidiary has its own board of directors.
tax free spin-off --> differ tax paid (no cash involvement)

Distribution of shares in a subsidiary to existing shareholders of parent firms as a (non-cash) dividend --> usually pro rata (not change ownership structure)
No cash inflows to parent firms.
creates publicly held stock in subsidiary and reduces or eliminates parent ownership in subsidiary.
established an independent board of directors and grant decision making authority to subsidiary management.
Divest asset - on a tax efficient basis (subsidiary shares distributed to shareholders are not taxed)

Rationale for Leveraged Buyout (LBOs) and Leverage Recapitalisations

Debt-to-equity and equity-to-debt swaps --> involve major debt-holders and shareholders and not public investors.
Leverages acquisition: --> target become a private firm

An acquisition where the purchase price is financed through a combination of equity and debt and in which the cash flows or assets of the target are used to secure and repay the debt.
LBOs have become very attractive as they usually represent a win-win situation --> the financial sponsor can increase the returns on his equity by employing the leverage; banks can make substantially higher margins due to higher interest chargeable.
The management of the target is usually retained and often takes an equity interest in new company.

the incumbent management team acquires a sizeable portion of the shares of the company.
Face a conflict of interest, being interested in a low purchase price personally while at the same time being employed by the owners who obviously have an interest in a high purchase price.
To minimize conflict of interest: Owner (offer a deal fee if certain price threshold is reached); Financial sponsor (offer compensation of lost deal fee); or earn-outs scheme (purchase price being contingent on reaching certain future profitabilities).

Change of corporate governance, allow manager to have better incentives.
better compensation structure and management are kept on their toes through threat of bankruptcy, reduced free cash flow.

Asset structure: more assets, so it can be sold to pay debt.
Capital structure: low debt --> reduce financial distress.
Operating performance: strong performance --> less value creation to repay debt
Cash holdings: large amount of cash to pay debt.
Management incentives: less incentives and use available cash to pay debt.
Ownership structure: concentrated --> easier to negotiate and to control major shareholders.

Work smart and think creative!!